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Mexico's Financial Crisis of 1994-1995

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Mexico's Financial Crisis of 1994-1995 Mexico's financial crisis of 1994-1995 The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters Citation Musacchio, Aldo. "Mexico's Financial Crisis of 1994-1995." Harvard Business School Working Paper, No. 12–101, May 2012. Citable link http://nrs.harvard.edu/urn-3:HUL.InstRepos:9056792 Terms of Use This article was downloaded from Harvard University’s DASH repository, and is made available under the terms and conditions applicable to Open Access Policy Articles, as set forth at http:// nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of- use#OAP Mexico’s financial crisis of 1994-1995 Aldo Musacchio Working Paper 12-101 May 8, 2012 Copyright © 2012 by Aldo Musacchio Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. Mexico’s financial crisis of 1994-1995 Aldo Musacchio Abstract This entry explains the causes leading to the Mexican crisis of 1994-1995 (known as “The Tequila Crisis”), and its short- and long-term consequences. It argues that excessive enthusiasm on the part of foreign investors, not based on Mexico’s fundamentals, and weak regulation of the banking system led build the vulnerabilities that left Mexico exposed to a sudden change in investor appetite to invest in the country. Political violence in Mexico and changes in monetary policy in the United States then led to radical changes in investor perceptions of the future of the country and to a balance of payments and banking crisis. The chapter then explains how the crisis unraveled and describes the US bailout of the Mexican government in 1995. The chapter ends examining the subsequent development of the Mexican banking system. Keywords for index: Financial crisis, banking crisis, Tequila crisis, Mexico, Carlos Salinas de Gortari, Miguel de la Madrid, NAFTA, bank privatization, foreign bank entry, FOBAPROA, EZLN, bailout, Luis Donaldo Colosio, JEL codes: E44, F31, F32, ***This working paper will be part of the Encyclopedia of Financial Globalization TABLE OF CONTENTS ORIGINS OF THE CRISIS 3 Trade liberalization 4 Liberalization of Capital Flows 6 The Mexican peg 7 THE CONSEQUENCES OF FINANCIAL LIBERALIZATION 8 Mexico’s bank privatization 8 Investor Enthusiasm 12 THE SYSTEM UNDER STRESS IN 1994 14 CONSEQUENCES OF THE 1994 CRISIS 17 Crisis and the US Bailout 20 WHAT DID MEXICO GAIN IN THE LONG TERM? 22 References 23 Mexico’s financial crisis of 1994-1995 The Mexican financial crisis of 1994-1995, also known as the “Tequila Crisis,” refers to the crisis that started after Mexico’s devaluation of the peso in December 1994. It precipitated the worst banking crisis in Mexican history (1995-1997), the largest depreciation of the currency in one year, from about 5.3 pesos per dollar to over 10 pesos per dollar between December 1994 and November 1995, and the most severe recession in over a decade (with GDP falling over 6%in 1995). According to Obstfeld and Taylor (2004), there were two major waves of financial globalization in the twentieth century, one before 1914, and a second that began in the last three to four decades of the century, and peaked in the 1990s. The Mexican financial crisis was particularly important as the first global crisis of this second wave. It raised significant issues about international financial architecture and the role that international bailouts should play in the latest era of financial globalization. Origins of the crisis Mexico undertook large scale reform and deregulation of its economy in the second half of the 1980s. Among those reforms, President Miguel de la Madrid’s (1982-1988) decision to liberalize trade and international capital flows were crucial to foster Mexico’s integration with the developed world. His government reduced import tariffs rapidly as part of the Uruguay round of trade negotiations under the General Agreement on Tariffs and Trade (GATT). Furthermore, de la Madrid pursued a series of reforms that facilitated the inflow of portfolio capital and foreign direct investment into the Mexican economy and the expansion of its domestic financial system. Then, in the early 1990s, the administration of President Carlos Salinas de Gortari (1988-1994) commenced negotiations for a foreign trade agreement with the United States, later known as the North American Free Trade Agreement (NAFTA), and further liberalized the financial system, privatizing the largest commercial banks and deregulating the banking system. Trade liberalization Since the Great Depression, the Mexican government followed a strategy of import substitution industrialization (ISI). Under ISI the Mexican government instituted a series of policies and regulations to protect domestic industries from international competition. This approach installed not only high import tariffs, but also non-tariff barriers on the importation of foreign goods, and provided subsidies to aid Mexican industries. Under this model, the country’s producers had no incentive to export manufactures because they enjoyed a captive domestic market with little or no competition. The Mexican model of development, based on ISI, continually ran into trouble in the 1970s and 1980s. Except for auto manufacturers and maquiladoras, companies operating under the ISI model did not export much and it was hard for them to get enough foreign exchange to pay for imported capital equipment and intermediate goods. Moreover, severe shortages of foreign exchange also could jeopardize the foreign debt service of the Mexican government, generating damaging exchange rate crisis. In fact, the country had balance of payments crises, i.e., had to devalue its currency, in 1954, 1976, and 1982. Between 1979 and 1981 the Federal Reserve Board raised interest rates in the United States to record levels to contain inflation in that country, with European central banks also raising rates simultaneously. This interest-rate increase perversely affected Mexico and other developing countries across the board and was even more damaging because it was accompanied by a rapid decline in commodity prices (Cardoso and Helwege, 1992). This combination of external shocks led to the decline in export receipts, an increase in the cost of servicing debts denominated in foreign currencies, and pressures over the exchange rate. In August 1982 the administration of José López Portillo (1976-1982) announced a moratorium on Mexico’s foreign debt service and started a process of renegotiation that was not finalized until 1989, under President Carlos Salinas de Gortari. Moreover, as Mexico suspended payments, investors around the world panicked, leading to an increase in interest rates that pushed other countries in Latin America to also suspended payments on their debts. The crisis led the countries in distress to request financial support from the International Monetary Fund and the World Bank (Stallings and Kaufman, 1989). These institutions, rather than just bailing out the countries, made loans and technical support contingent on a series of economic reforms. The reforms were aimed at achieving macroeconomic stability, reducing government intervention in the economy (i.e., promoting privatization, deregulating, and strengthening the protection of private property), and liberalizing the economy to international trade and capital. The balance of payments crisis of 1982 led to a radical transformation of the Mexican government’s development model. Miguel de la Madrid, president of Mexico (1982–1988) for the Party of the Institutionalized Revolution (PRI in Spanish), became one of the leading reformers in Latin America. He adopted policies to deregulate many industries, started a massive program to privatize numerous government-owned enterprises, and began to liberalize trade across the board. For example, his administration unilaterally decreased the maximum import tariff from 100% to 20% and lowered other tariff and non-tariff barriers. The administration also lifted restrictions on foreign investment in many sectors; in particular, allowing foreigners to own 100% of manufacturing businesses outside of major cities. After 1988 President Salinas, also of the PRI, continued with economic reform and trade liberalization. In particular, his administration negotiated the North American Free Trade Agreement with the United States and Canada. Under NAFTA the government lowered tariffs even below the levels required for most-favored nation status, or eliminated them altogether, for trade within North America. NAFTA also opened up the country to foreign direct investment in most sectors (except sectors considered strategic like banking and energy) and developed a series of treaties to enforce transnational investment and trade contracts (Lederman, Maloney, and Servén, 2005 and Iyer, 2005). Liberalization of Capital Flows In 1989 the Mexican government finalized the renegotiation of Mexico’s public and foreign debt with a group of international creditors, an event that allowed Mexican companies and banks to start borrowing again in financial markets abroad. Almost simultaneously the government changed the Foreign Investment Act to allow greater freedom for foreigners to invest in the Mexican stock exchange. (It created options to purchase B shares, with no controlling rights, or ownership in mutual funds that held A shares of Mexican companies.) After 1993 the capital account of Mexico was further liberalized and the government allowed the local stock market to trade foreign securities.1 The effects of these reforms can be gauged by looking at Mexico’s balance of payments in Table 1. For instance, after 1991 net foreign direct investment went from over $2 billion 1 For a summary of some of the changes see Aspe Armella (1993), chapters II and III or Santín Quiroz (2001), chapters 2 and 4. dollars per year to over $4 billion dollars per year. Portfolio inflows increased considerably after 1989, going from practically zero (due to controls) to $3.4 billion in 1990, $12.7 billion in 1991, and $18 billion in 1992.
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